Archive for May, 2004

May 23, 2004

BOOK REVIEW: The Innovator’s Solution

Clayton Christensen & Michael Raynor

RATING: 4 Stars

Every year, there are dozens of books published on business strategy. Most of them are eminently forgettable. This one is an exception. It should be read by everyone who has responsibility for establishing a business strategy (or aspires to such a position), and should also be useful for those involved in running non-profit organizations, specifically including universities. It will also be of value to investors, who (except for those who are pure short-term traders) should be making conscious judgments about the strategies of the companies in which they invest.

In this book, the authors develop four major themes, which are amplified using examples ranging from semiconductors to automobiles to milkshakes:

1) Disruptive innovations–those destined to change the structure of an industry–tend to attack from below. They usually first appear in a form that is in some ways inferior to the existing dominant technologies, and hence are unlikely to get the attention or respect of industry incumbents.

2)In a venture dedicated to the introduction of a disruptive technology–whether a start-up business or a division of a larger company–early profitability is more important than early rapid growth. (This is a very contrarian opinion in some quarters.)

3)When attractive profits disappear in a market as a result of commoditization, the opportunity to earn attractive profits will usually emerge at an adjacent stage of the value chain.

4)In segmenting a market, the purpose for which the product is being bought (“circumstance,” in the terminology of the authors) is a more useful dimension than the attributes typically used, such as customer demographics or product features.

A bit more on each of these themes:

1) Disruptive innovations–those destined to change the structure of an industry–tend to attack from below. As their first example, the authors offer the steel industry. When minimills (which make steel from scrap using electric arc furnaces) first appeared, the incumbent “big steel” companies weren’t too worried. The quality of the steel initially produced by the minimills was marginal, and their products were mainly useful for concrete reinforcing bar (rebar). Rebar was viewed by big steel as a scruffy market, with poor profit margins, and they weren’t all that sorry to be rid of it.

But over time, the minimills improved their quality to the point where they could make products on increasingly high values: first bar and rod, then structural steel, and finally sheet steel. At each point, it was possible for big-steel execs to convince themselves that they held a quality advantage for all products above the level at which the minimills had then attained. We know how this story ends, and it isn’t pretty.

As another example of the disruptive attack from below, the authors cite transistor radios. Initially, the incumbent makers of (vacuum-tube-based) radios and record players did not view the quality or volume of sound that could be obtained from transistors as being good enough for their markets, and they focused on R&D to improve the performance. But when Sony introduced the world’s first pocket transistor radio (in 1955), it targeted teenagers (“the rebar of humanity,” say the authors snarkily.) “The portable transistor radio offered them a rare treat: the chance to listen to rock and roll music with their friends in new places out of the earshot of their parents. The teenagers were thrilled to buy a product that wasn’t very good, because their alternative was no radio at all.”

Again, the incumbents weren’t particularly worried…their own, higher-end markets were still doing OK. But “When solid-state electronics finally became good enough to handle the power required in large televisions and radios, Sony and its retailers simply vacuumed out the customers (from the traditional markets–ed)…Within a few years, the vacuum tube-based companies, including the venerable RCA, had vaporized.”

2) In a venture dedicated to the introduction of a disruptive technology–whether a start-up business or a division of a larger company–early profitability is more important than early rapid growth. This goes directly against the popular “get-big fast-you-can-worry-about-profitability-later” mantra, but Christenson and Raynor make good arguments for their position. “Competing against nonconsumption and moving disruptively up-market are critical elements of a successful new-growth strategy–and yet by definition, these disruptive markets are going to be small for a time.” Venture managements which are on the hook for unreasonable early growth targets are likely to launch doomed frontal attacks on entrenched competitors in existing, large markets, rather than patiently growing new markets in which they have the edge. And when venture management is told not to worry much about profitability in the early stages, there are other problems. “When new ventures are expected to generate profit relatively quickly, management is forced to test as quickly the asumption that customers will be happy to pay a profitable price for the product–that is, to see whether real products create enough real value for which customers will pay real money. If a venture’s management can keep returning to the corporate treasury to fund continuing losses, managers can postpone this critical test and pursue the wrong strategy for a long time.”

The authors go so far as to say this: “If you’re slated to lead a new venture and corporate management says you need to become very big very fast, what you are really hearing is that management is going to make you cram your disruptive technology into an established market. When you sense this, don’t take the job. You are very likely to fail.”

3)When attractive profits disappear in a market, as a result of commoditization, the opportunity to earn attractive profits will usually emerge at an adjacent stage of the value chain. (The authors call this “the law of conservation of attractive profits” and attribute it to Chris Rowen, CEO of Tensilica.) For example: As the PC industry commoditized, value migrated from the PC manufacturers (assemblers, basically) to lower levels in the value chain: the makers of the microprocessor (Intel) and the operating system (Microsoft). “Money also flowed to the makers of dynamic random access memory (DRAM), such as Sansung and Micron, bu not much of it stopped at those stages in the value chain in the form of profit. it flowed through and accumulated instead at firms like Applied Materials, which supplied the manufacturing equipment that the DRAM makers used.”

The authors see something similar happening in the auto industy, with value migrating away from the auto manufacturers to their first-tier suppliers. They see the automotive majors as having falled into a trap, just as IBM did earlier with PCs: “General Motors and Ford, with the encouragement of their consultants and investment bankers, have just done the same thing. They had to decouple the vertical stages in their value chains in order to stay abreast of the changing basis of competition. Butg they have spun off the pieces of value-added activity where the money will be, in order to stay where the money has been.”

4) In segmenting a market, the purpose for which the product is being bought (“circumstance,” in the terminology of the authors) is a more useful dimension than the attributes typically used, such as customer demographics or product features. As an example, the authors offer a restaurant chain which was trying to improve results for its milkshake product line. “The chain’s marketers segmented its customers along a variety of psychobeharioral dimension in order to define a profile of the customer most likely to buy milkshakes. In other words, it first structured its market by product–milkshakes–and then segmented it by the characteristics of existing milkshake customers….both attribute-based categorization schemes. It then assembled panels of people with these attributes, and explored whether making the shakes thinker, chocolatier, cheaper, or chunkier would satisfy them better.”

Marketing 101 stuff. But it didn’t yield much in the way of results.

A new set of researchers came in with a different approach–to understand what customers were trying to get done for themselves when they “hired” a milkshake. They spent an 18-hour day in a restaurant and recorded when the shakes were bought, whether the customer was alone or with a group, whether he consumed it on the premises or drove off, etc. Surprisingly, most of the milkshakes were being bought in the early morning. After analyzing the data, the researchers returned and interviewed the customers. Evidently, these were people who faced a long, boring commute and wanted something to eat/drink on the way. Milkshakes were superior to alternatives because they didn’t get crumbs all over (like bagels) or get the steering wheel greasy (like a sausage & egg sandwich.)

The most important thing is that the same customers, at different times of the day, would buy milkshakes in other circumstances/contexts…and the desirable product attributes would be different. For example, they might come with their kids after school. And whereas the same person in his role as a commuter might want something that is relatively slow to drink (thick shake, large container), when he reappears in his role as a parent he might want something that goes down relatively fast (less viscous shake, smaller container, maybe even a larger straw.) What matters is not just who the customer is, but what he is trying to do.

The example may seem like a fairly trivial one, but the conceptual point is an important one. (I would also note that research projects are not the only way for a company to learn about things like the milkshakes-for-breakfast phenomenon…encouraging front-line employees to be alert and involved, and to communicate their observations and suggestions, is also important. The people working in the stores probably knew about the milkshakes-for-breakfast trend long before the study was conducted.)

One of the most interesting (and sobering) passages in the book is the one in which Prof Christensen describes a recent MBA class. He had written a paper postulating that the B-schools’ traditional MBA programs are being threatened by two disruptions: executive evening–and-weekend MBA programs (allowing working managers to earn their MBA degrees in as little as a year) and the growth of on-the-job management training at institutions like Motorola University and GE Crotonville.

After reading the paper, Christensen asked the students “how many of you think that the leading MBA programs are being disrupted?” Only three out of 102 students raised their hands.

Those who weren’t concerned–the vast majority–tended to point to quantitative data–the numbers of students battling to get into the leading schools, the starting salaries of the graduates, etc etc. Christensen asked one of the most vocal defenders of “the invincibility of the leading business schools” this question. “What if you were dean of one of these schools. What data would convince you that this was something that you needed to address?”

“I’d look at the school’s market share among the CEO’s of the Global 1000 corporation,” the student responded. “If our market share started to drop, then I’d worry.” Christensen pointed out that market share, measured in this way, is distinctly a lagging indicator, and that by the point it began to drop, it would be game over.

It’s worrisome that so many students at a leading business school–even after being taught by a world expert in disruptive innovation–showed such lack of astuteness in assessing a potential disruptive innovation that was right in front of their noses. (On the other hand, it’s a very positive thing that so many of them felt free to openly disagree with their professor.)

There’s lots more in this book. Clayton Christensen is a professor at Harvard Business School, and Michael Raynor is a Director at Deloitte Research.

Recommended.

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